07.02.2013
By Terry Flanagan

Stock Selection Ahead

One Chicago hedge fund start-up has an innovative idea on how to generate market-beating returns: buy stocks that will outperform the market.

This ‘back-to-the-future’ long-bias investing strategy can be effective as correlations decline and interest rates tick higher, said Scott Wallace who launched Ranger Opportunity Partners three months ago with $5 million in seed capital.

“Individual companies will begin to matter more” as the trend of the overall market “trading like one big stock in an unusually low interest rate environment” dissipates, Wallace told Markets Media.

“Go back 20 years — hedge funds were biased long, and not worried about every risk,” said Wallace, who was previously a portfolio manager at AllianceBernstein. “They focused on large holdings that they had a belief in.”

Traditional, long-only asset managers are being compressed into smaller categories, restraining them by narrowing definitions that can harm performance, according to Wallace. While the structure of a hedge fund can reduce constraints, equity managers in that space “have been solving for the wrong variables.”

“They’ve been solving for low risk and getting low returns,” as evidenced by hedge fund performance lagging U.S. indexes in recent quarters, Wallace noted.

Wallace is attempting to exploit an “unexplored middle ground” of unconstrained investing techniques married with a bullish view. The strategy is heavily oriented to stock selections, with comparatively large positions in single companies. “Individual company fundamentals will matter more than they have for a long time,” he said.

To protect capital and dampen volatility, Wallace may deploy put spreads or take single-stock short positions in “structural underperformers.”

Wallace, who was managing director and head of equities in Japan at JPMorgan, is chief investment officer of Ranger. He has one part-time colleague to manage operations, compliance, finance, and marketing.

“The cloud has made starting a business much easier,” as the computing technology facilitates management of documents, investing, risk models and fund flow “in a really quality way,” Wallace said. “I could manage a substantial amount of money and never have to manage any of my own IT infrastructure.”

Of the 50 biggest U.S. hedge funds reported in January 2013 by Barclay Hedge, only four were Chicago-based: Citadel Investment Group ($13  billion), Mesirow Advanced Strategies ($11 billion), Aurora Investment Management ($10 billion), and Magnetar Capital of Evanston, IL ($9 billion).

Wallace respects the freedom of thought that comes from being outside of New York as a short-term contrarian making longer-term investing decisions. “A lot of firms and funds grew out of the trading floors” of the big exchanges in the Second City, and “this is where a lot of intellectual capital and property is,” he stated.

Sometimes a start-up can feel “amoeba”-sized in an industry estimated at $2 trillion worldwide, and the largest 241 hedge fund firms in the U.S. collectively managing $1.3 trillion, Wallace said. Still, there is “good evidence to suggest smaller managers tend to do better,” Wallace said.

That subject is controversial, but research published in October 2012 by data monitoring and software firm PerTrac showed small funds with assets less than $100 million outperformed rivals managing five times as much in 13 of the last 16 years. The annualized rate of return between 1996 and 2011 was 12.5% for small funds, 9.9% for mid-sized funds, and 9.1% for funds with more than $500 million.

 

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