Letter #233: Izzy Englander (2009)
Founder of Millennium Management | Keynote Speech
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Israel (Izzy) Englander is the Founder and Managing Member of Millennium Management and Millennium International Management, as well as the general partner’s Chairman and CEO. He founded Millennium in 1989 with $35mn AUM ($5mn of his own money), which he has grown to ~$70bn today (2,000x in 35 years). Prior to founding Millennium, Izzy was a founder of Jamie Securities & Co. Before starting Jamie, Izzy formed and ran the floor brokerage house I.A. Englander & Co. after purchasing a seat on the American Stock Exchange when they began to list options. He started his career at Kaufmann, Alsberg & Co., where he focused on trading convertible securities and options. Prior to joining Kaufmann, Izzy had interned at Oppenheimer & Co. during college after having started trading stocks in high school.
Today’s letter is the transcript of a speech given by Izzy Englander at the Absolute Return Symposium 15 years ago this week, right as the US was emerging from the 2008 Financial Crisis. In this speech, Izzy discusses the topics of transparency, alignment of interests, risk management, liquidity and duration of capital, focus on core competencies, regulation, and more!
I hope you enjoy this speech as much as I did!
Related Resources:
Transcript
I don’t have to tell anyone here that the last 18 months or so have been difficult times for just about all of us in the hedge fund community. In our case at Millennium, we came through the difficulties reasonably well—we were down about 3% last year, 2.5% of that because of assets that got trapped at Lehman when it filed bankruptcy. (I might note, by the way, that unlike some other funds, last year we wrote off our entire net exposure to Lehman.) But, as you can imagine, the last year was difficult for us at Millennium just as it was for all of you.
The impact of the credit crunch is going to be with the entire industry for the foreseeable future. I don’t mean just in terms of the loss of capital, but also in terms of the legacy it will leave. It will affect how hedge funds do business and how they manage risk, and it will affect managers’ relationships with their investors. We’ve all changed, because we had to change. In the long run, maybe it’s good for us.
There has been a lot of media coverage and talk in the industry recently - and there will probably be more discussion today - about what is new and different and changing in the industry. Today I’m going to talk about some of these changes and how Millennium is adapting, and how I think we and the rest of the hedge fund community need to continue adapting to a changed world. Some of these changes are for the best, some maybe not. But I’m also going to talk today about what is not changing, and what shouldn’t change in the industry in general. The core principles that have made the industry so successful shouldn’t change, and by strengthening and relying on these core themes, we can make sure that our businesses remain critical participants in the financial world and continue to be an important allocation for institutional investors in the years to come.
I don’t think there’s any question that there’s been some shift in the “balance of power” in the manager/investor relationship in the last year or two. But I think it’s often over-emphasized by the media. Hedge fund managers are feeling pressure to make changes to what some people like to call the “investor friendliness” of their funds. At Millennium, we’ve been feeling this pressure for change and we embrace it. It’s the right thing to do. This is part of institutionalization, and in fact we’ve been institutionalizing our business for a while now. Investors across the industry are asking for:
greater transparency,
stronger risk management,
better liquidity,
more favorable or flexible terms, and
an increased focus on core competencies.
They should also be focusing on how well the managers’ financial interests are aligned with their own.
Unfortunately, we’ve seen some investors approach this by creating universal checklists, “what all funds must have,” forgetting that what has made hedge funds successful and unique investment opportunities is their ability to be opportunistic, to be flexible, to be entrepreneurial, and to adapt quickly to changing markets. These don’t necessarily translate very easily into a check-the-box “hedge fund report card.”
Transparency
Let’s start with the demand for transparency. This demand—like a number of others—comes straight out of the Bernie Madoff scandal. Understandably, a lot of people were embarrassed that when the music stopped, they had money with Madoff. And out of that situation, basically, a lot of investors came to us and to other funds and said “prove you’re not another Madoff.”
In broad outline, we’ve done two things to respond. First, we’ve allowed investors to see a lot more than we used to. Not essential information that could be competitively damaging, but we disclose much, much more than we used to. The second thing we’ve done is related to that same concept—we’ve brought in independent third parties to review and verify various aspects of our business. We now have two audits a year by a “big four” accounting firm (Ernst & Young). We have an independent administrator—GlobeOp® Financial Services—who’s checking with our prime brokers and other institutions to confirm that we really do have the positions that we say we have, and then to confirm the valuations we put on all those positions. We now have, and this is not—or, at least, not yet—typical of the industry, a Type I “SAS 70” review, which is an analysis of our internal controls reported on by our independent auditor. We also have RiskMetrics™ Group looking at our portfolio, preparing independent risk analyses of the portfolio, double checking with our own risk department for accuracy and completeness and then reporting the analyses to our investors. As near as I can tell—and I think we’re pretty close to typical among the large hedge funds—that’s much more independent verification than you’ll find in any other industry.
When Goldman Sachs puts a value on a position, everybody accepts it. When Citigroup puts a value on a position, everybody just accepts it, even though if last year taught us anything it is that Citi isn’t very good at putting values on positions. When a hedge fund puts a value on a position, first we have to get some highly regarded independent verification that we really do hold that position somewhere, then we have to get independent verification of the value of the position. Why do I feel like Rodney Dangerfield?
A while back we recognized that Millennium had become an institution, and that we needed to build an institutional infrastructure. We made a commitment to it. We brought in a former General Counsel of the SEC to establish a world class legal and compliance team, and he’s done it. He tells me—and I have to believe him—that he’d match our legal and compliance structure pound for pound with any firm on the Street—and I don’t just mean other hedge funds. We’ve worked hard—and spent a lot of time and money—to develop a culture of compliance, where it’s not just the letter of the law, it’s the spirit of it. In order to make this successful, I think you really have to demonstrate senior level buy-in. What they say about the “tone at the top” is important. I don’t care who you hire, if they don’t have committed support at senior levels, they won’t be able to do the job. I’ve guaranteed our people that they have that kind of support from me.
Alignment of interests
Basically, when I think about hedge fund investments from an investor’s perspective, the things I’d really be interested in knowing are how well the managers’ interests are aligned with mine, and how much of their personal net worth the managers have invested in the fund. I guess I also want them to have a sizeable net worth so that their investment will mean something and they’ll care about protecting it. In our case, my biggest personal investment, by a fair measure, is my investment in Millennium. The same is true of a number of our top executives and traders. I think our compensation structure keeps our interests well aligned with our investors’, and that’s the way it should be. Why should managers get rich while their investors are losing money? Recently, I met with the head of a public pension fund who said to me, “why should managers live in chateaus while we lose money?” I agree with him. That’s not what I call alignment of interests.
I’ll repeat what I think ought to be the three critical questions for investors:
How well are the managers’ financial interests aligned with the investors’?
Does the manager have significant skin in the game invested alongside the investors’?
Is this the type of strategy that I want to make an investment in?
If the answers to those questions are right—and I’m assuming the fund has a solid track record of good returns over a significant time period, audited by a major independent auditing firm, or the investor shouldn’t even be talking to them—the investor’s done a majority of the analysis it needs to do.
Risk management
People will argue for a long time about who should’ve seen what coming in 2008. And, of course, some people did predict exactly what happened—either because they’re smart, or because they threw something up on the wall, and that’s what stuck. I heard somewhere that the only people who predicted the crisis of 2008 were the people who’d predicted 7 out of the last 2 recessions. Over time, we’ll find out who was smart last year and who was lucky, but one thing is clear—there weren’t a lot of people who saw it coming and took appropriate action, and the people who did do that weren’t working at the major financial institutions.
On this one, we may have been lucky at Millennium, but I’ll tell you a secret of mine. I don’t like to lose money. I like to make money, of course, but I really don’t like to lose it. So even back in early 2007 and earlier, before any of the problems hit, we had a risk management group that was about 3 or 4% of our total employee base. With all that’s happened, that’s become a group that investors want to know all about, but we were at least focused on the issue, and were paying attention to the function, long ago. When things looked uncomfortable a year or 18 months ago, we drove as far south as we could as fast as we could. I like to think that one of the reasons we came through last year comparatively well was that we had good, tough risk management and we approached the uncertainties with discipline. We have always run the fund to avoid taking a chance for spectacular gains at the risk of spectacular losses – we typically hedge out some of the upside in any investment to avoid much of the downside. We think our ability to manage risk differentiates us, and it’s something we’ve always put a premium on. I think we pay more respect to the tails of the bell curve than most funds do: we tend to be at the tighter end of the spectrum. We never want to be the market; we always want to be participants in the market.
In this respect, our risk management practices aren’t changing. But the way we communicate these practices to our investors and the level of transparency we provide with regard to our risk management is increasing.
One of the benefits of a multi-strategy business like ours is that not only do we actively hedge exposures at the trading team level – where we have over 100 groups of portfolio managers under our umbrella -- but we also have the advantage of managing the firm-wide exposure at the aggregate level. This essentially allows for two bites at the risk management apple. It’s really an active approach to managing risk, and it’s worked fairly well for us over the years. Last year I think it saved us from the worst of it all.
The days of being on top of the trading, and leaving the risk management guys in a different room—if those days ever made sense, they’re over now.
Liquidity and Duration of Capital
I think we all learned this lesson once again last year. If you go back two or three years, you’ll see a lot of talk in the press about “convergence” between hedge funds and private equity, and there was a lot of that going on. Hedge funds were engaging in private equity activities and private equity funds were putting on a lot of trades that looked like they belonged in hedge funds. So then fast-forward to the fall of 2008, and what do we see? Even a lot of the things people thought were pretty liquid turn out to be not-so-liquid after all when there’s a global credit crunch of enormous proportions. No matter how you look at it, the sight was not a pretty one. Funds were under the gun and investors were frustrated.
Needless to say, liquidity became the watch word. We all became hedge funds again, and decided that private equity wasn’t where we wanted to be. For us at Millennium, it was fortunately not too tough. We’d had maybe 1 or 2% of our gross assets in relatively less liquid positions, and we could adapt. But for all of us the movement toward maintaining liquidity took on a new degree of importance, and I think you’ll see everyone in the community paying more attention to that in the future.
Bottom line, I don’t see convergence with private equity as the coming thing any more, certainly not for Millennium. One thing our industry surely needs to focus on during the next phase of its evolution will be better matching the duration of investors’ capital with the fund’s investment horizon. Funds with liquid strategies can offer more frequent liquidity, but it should remain the manager’s prerogative to offer it or not. Every fund is different, and there shouldn’t necessarily be an industry norm or baseline for investor liquidity terms, but it is really important that every manager clearly communicate their investment approach and time horizon to prospective investors, and that investors fully understand whatever limitations are put in place.
If funds don’t get their investment durations in line with their investors’ liquidity needs, we’re going to end up seeing a lot more side pockets. It’s inevitable. And given the way our industry works, pretty soon you’ll see markets being made in side pockets, with bid-offer spreads. In fact, it’s probably happening somewhere right now—I just haven’t seen it yet.
At Millennium, we’ve become much more selective in this regard. We have changed the way we think about it. If an investor wants you to check a box on their list that doesn’t mesh with your investment thesis and what you need to do to run your business the right way, then maybe this isn’t an investor that belongs in your fund. We should all be going through a little bit of due diligence with our investors the same way they do with us—it helps in making sure the interests of the manager of a fund are well aligned with the interests of investors in that fund.
Focus on core competencies
We learned another lesson from the credit crunch. Watch out for style drift. Like a lot of people, we’d been guilty of it—not very much, but a little bit. Now, we pretty much try to invest 100% the way we really know what we’re doing. Every successful manager has some kind of an edge. That’s how you get to be a successful manager. It’s important to remain completely focused on taking advantage of that edge, and maintaining discipline. At Millennium our edge revolves around staying nimble, allocating funds to capital-constrained strategies, focusing on sectors with alpha opportunities where our traders have particular expertise, and managing risk every step of the way. We’re playing to our strengths, not our weaknesses. We’re staying liquid, and we’re staying hedged, because that’s what our portfolio managers have established they can do. Equally important, that’s what we’re sure we know how to manage.
I think we’re pretty good at what we do, and I think our record—our returns, with our Sharpe ratio of around 2.5 over the last twenty years—speaks for itself. For a sizable fund—let’s say funds with more than $5 billion under management—we’ll be in the top group of funds over the total period with the kinds of numbers we’ve been fortunate to generate. But that doesn’t mean we’d be good at just anything we might think of. It means we’re good at what we do—running a true hedge fund. Very rarely do we make a big momentum bet – we focus on achieving high diversification, with small gains, and doing it consistently – a lot of nickels and dimes day in and day out – generating “true alpha.” It doesn’t mean we’d be good at running a private equity fund or a distressed credit shop. Maybe we would, but it’s unproven. We don’t want to be everything to everyone – and no other hedge fund should try to be either. It’s just not what our industry is about. As Michael Jordan proved, just because you’re a great basketball player doesn’t mean you can be a great baseball player.
So for us at Millennium, one of the big lessons of last year was to work on keeping the grass green on our side of the fence, and to forget about looking over the fence at somebody else’s grass. The grass may look pretty green on the other side of the fence, but the fertilizer can be very expensive.
Regulation
Finally, I’d like to make a few remarks about something that we cannot directly control, but something that is on everybody’s minds these days –hedge fund regulation. Now, of course, the fact is that last year we had a global crisis that hedge funds did not cause, were not a part of, and had very little to do with, apart from suffering like everybody else. Most of the problems were caused by the very highly regulated banks and insurance companies. But hedge fund regulation is going to be part of the solution.
When I think about it, it seems to me that the reason the system allowed the big banks to get to such high levels of leverage was that everybody thought that under the watchful eyes of the Fed and the other bank regulators, the big regulated institutions were safe. And the reason no one would extend comparable leverage to hedge funds— especially after the Long Term Capital Management debacle—was that they knew hedge funds were not subject to any such strict oversight making sure they were safe.
People have suggested that the crisis of 2008 was a failure of market capitalism. I think maybe it was just the opposite. I think where the markets were allowed to work freely, they worked, and hedge funds were prevented from taking on excessive leverage. Where there was failure was in the institutions that were deeply involved in a regulatory environment. How the politicians take those facts and weave them into a demand for more hedge fund regulation, I don’t understand, but that is what we see happening.
What is worse, I get the impression some of the people doing the reordering of regulation really don’t really understand the market. Hedge funds, proprietary trading desks at banks and investment banks, funds-of-funds and maybe especially funds of managed accounts, each have an entirely different set of regulatory and accounting standards, not to mention that some of them have privileged access to funding. Because the accounting is so different, the average person—be he an investor or an economist or whatever—thinks they look like completely different entities. You just cannot make a comparison. It is apples to coffee. So even though we are all competing with each other, no one can compare us. Being able to make a good comparison between different funds should be critically important to investors, but right now it’s hard to do, and to tell the truth, some of the investors don’t try very hard.
This difficulty in comparison especially shows up in expenses, and it relates to the alignment of interests between managers and investors that I was talking about a minute ago. You have one fund that is very large, and has a fairly small management fee, and is running a fairly simple shop. Let’s call it a $20 billion shop, basically long only, not getting into complex deals or one-off deals. If they’ve got a 1% management fee, that’s $200 million a year. With basically a pretty simple structure, their costs are maybe $100 million, and that leaves $100 million for the manager to take home at the end of the year, whether they earn anything for investors or not. That’s not what I call alignment of interests.
Then take another fund with a complex structure, multi-strategy with some high-volume trading and long-short fundamental traders, some macro strategies, maybe a little fixed income, etc. Maybe it’s a $10 billion fund with a 3% management fee. The manager there is getting $300 million but the expenses of running that type of organization, which require greater infrastructure to be more competitive and have a better risk adjusted return with little or no correlation to the market—those expenses are pretty steep. I’d guess they add up to about $300 million. So in that case, the management fee is basically break-even to the manager, and the manager’s financial interests are well aligned with investors’.
In those two funds, if you’re looking at an investment and you just compare the 1% fee with the 3% fee, you’re looking through the wrong end of the telescope. I’ll go back to what I said earlier. If you can make sure the investors’ interests are aligned with the manager’s, and if the manager has real skin in the game, you’ve taken care of most of the important diligence questions.
Now with this drive to regulation, what the regulators ought to be doing in my opinion, is providing some degree of clarification and uniformity so that investors and counterparties and everyone else—even regulators themselves—could compare us to each other, apples-to-apples. Compare funds of funds and funds of managed accounts and hedge funds and proprietary trading desks in a way that makes sense. Look through the management fee to see what’s really going on and if the management fee is generating profits so that the manager’s interests are mis-aligned with the investors’ interests. That would be useful regulation for investors and would get them thinking about the process the right way.
But I have not heard one word suggesting any idea of change in that direction. Instead of working to create a more level playing field, it seems as though the government is determined to keep our outlines hazy, as though we are all surrounded by a big fog, so that it is harder, rather than easier, for people to compare alternative sources of investment management.
I don’t want to spend a lot of time on regulation, but I want to say this: it isn’t something to be too afraid of. As it happens, when we started Millennium 20 years ago, the only way to get any leverage beyond Reg T was to have a broker dealer, so we formed a broker dealer, owned by the fund itself, and conducting business just for the fund. It doesn’t have any other clients or any outside business. As things developed with more modernization and globalization, you don’t need a broker-dealer any more, and you can get just about as much leverage as the lenders are willing to provide— regulation isn’t really a limiting factor any more—but we still have our broker-dealer.
As a result, we’ve been subject to SEC inspections and FINRA inspections and everything else. And you know what? I don’t think they’re so bad. Mostly, they’re looking for things you did wrong, but they’re also looking for ways to make your business run better, in full compliance with the law. I don’t mind that. It’s like going to the doctor for a physical check-up. They come in and give us a physical every so often. Sometimes it feels like I’ve gone to the proctologist, but that’s OK. It’s an important branch of medicine.
The real point is that the difference between investment adviser registration and broker-dealer registration is tougher on the broker-dealer side, and even there it really isn’t so bad. So it may not be that hedge fund regulation is a smart response to the financial crisis, but it isn’t something to get that worried about from the industry’s perspective. If it makes investors feel more comfortable about the industry, maybe there’s some good coming out of it too.
We obviously are in a unique phase of our industry’s evolution, and there are certainly a lot of things to think about. We’ve all changed in the last year, and we’re continuing to evolve. There’s an old Chinese curse that goes “may you live in interesting times.” Well, we do.
With that said, I’m happy to take questions.
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