A CIO’s view: Insights from 30 years of hedge fund investing 

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Kumar Panja: Welcome to the J.P. Morgan Making Sense channel and to another episode of Navigating the Hedge Fund Frontier. I'm Kumar Panja and I'm excited to be joined by my J.P. Morgan colleague, Paul Zummo, who is the Chief Investment Officer of Hedge Funds and Alternate Credit Solutions at J.P. Morgan Asset Management.

Paul Zummo: Great to be here, I really appreciate it and thanks for everybody for joining us today.

Kumar Panja: Thank you for being here, Paul. Congratulations on reaching the milestone of 30 years of investing in hedge funds. You and I were looking to do this podcast for some time, so I'm glad we could use the anniversary as a catalyst. And in fact, for our listeners, you'll find a link to a note published by Paul and the team attached to this podcast, which I encourage you to click on and take a look at when you have time. So in the next few minutes, we're going to talk about the hedge fund business at J.P. Morgan Asset Management, a little bit about its evolution, your approach to portfolio construction, and how they're setting themselves up for continued success. And then I'll be asking Paul to share some of the insights that he and the team have garnered over the last 30 years. Pearls of wisdom. So Paul, let's get into it. J.P. Morgan Asset Management has institutional DNA in investing in hedge funds. I mean, you've been doing it for three decades. That's a lot of money that's gone into the industry. That's a lot of money that's probably come out of managers. So you have a lot of data points. And when I think about the landscape in the early to mid 90s, that's very different to today. I certainly was just starting out in my career and it was firms like Quantum Fund, Moore, Tudor, Tiger, and Caxton. These are the firms that were being talked about at the time. So tell us a little bit about the journey from them and how that's led to the structure of the business today.

Paul Zummo: Yeah, there's been tremendous change, tremendous differences versus the early days. A number of things that come to mind. I mean, first is just the availability of data today versus where we were 20, 30 years ago. So important to remember that there was no internet, right? So half the challenge 30 years ago was just finding hedge fund managers. We would almost knock on door to door looking for LLCs and where people are located to see, are you a hedge fund? And so it was really difficult even to find hedge funds, really basic things. So the availability of data today is drastically different. The second thing, as you pointed out, is the strategy evolution. So both strategy evolution and also the commoditization of some strategies as well, which is kind of related. But yeah, back in the day, it was a lot of macro funds, a lot of long short funds. Once upon a time, there were a lot of merger arbitrage funds that you could make substantial money just in merger arbitrage. And some of those things have changed because of competitive pressures on the industry and managers and strategies. And today, you see obviously the rise of quant, the rise of multi-strat. So the strategy allocation is much different. The way we work with clients is much different as well, which maybe we'll get into as well. And then the last thing I'd say is just front on a risk management front. The understanding of things like financing and counterparty risk, the importance of those things, importance of risk management, drastically different today versus, certainly versus even 10 years ago, but versus 20 or 30 years ago, very, very different.

Kumar Panja: Right, so that sort of whole approach to portfolio construction, which is led by your client base, but also by the way that you have seen the industry evolve over that time. Okay, and if we talk a little bit about the size of the business and the kind of structure of it, geographic footprint, for example, what does it look like today?

Paul Zummo: Yeah, it's a global team. So we're managing about $33 billion. We recently integrated with the private bank's hedge fund business, which we could talk about if you like. But yeah, $33 billion, it's peak assets. Even without the private bank piece, we're still at peak assets. So we've seen very strong growth in the business. About 65 people supporting the business. Let's call it about half of those are involved on the research side, cross-investment risk or operation due diligence.

Kumar Panja: And if we talk about the competitive environment that you live in, that kind of fund of hedge fund model has faced some existential challenges over the last two decades in particular. And those of us in the capital advisory team who've been around for a few years, some of those household names have disappeared and others have become a shadow of their former selves. Yet, J.P. Morgan Asset Management has continued to grow over that period. How has that happened?

Paul Zummo: I think inevitably it's a large number of things, but certainly having the J.P. Morgan business card is helpful. Certainly, obviously a great firm, supportive firm, and that's helpful. I'd say a number of the decisions we've made over the years and just kind of the DNA of who we are has certainly played a role. So the way we've always thought about clients and early days kind of recognized that we were in the business of servicing clients and that led to customization of portfolios 25 years ago. And today, again, it's similar to how we function with clients. We have many of our clients who are actually investing in the hedge fund industry themselves, but they're using us as effectively a completion portfolio to kind of build out areas that they're not comfortable with or don't see on their own, whether that's Quant, emerging managers, other uncorrelated strategies. So I'd say being not only appreciative, but recognizing that what clients needs have evolved over the years and really adapting ourselves to it. And then maybe lastly, just our culture. Our culture has always been really, really strong and I've been extremely fortunate to have so many people on our team that have worked together for 15, 20, 25 years. And I think that's clearly been critical to our success over the years.

Kumar Panja: And you mentioned that your client base, the LP base, how has that changed over that time?

Paul Zummo: Well, it's always been a mix of institutional and high net worth, which I think is helpful because there's obviously differences between the two client bases and in many, many ways. And I think it will continue to evolve. I mean, what we've seen lately is it's certainly strong interest across both sides, but if I go back like five years ago, which is where we really started seeing more of a hockey stick in the growth trajectory or renewed one, at least, it was really the high net worth individuals that kind of led that, right? And just simply because, as the story resonates with them, they're able to act quicker. And for a high net worth investor, there's only so many alternative choices. And if you're looking to build a resilient portfolio, obviously hedge funds are a critical component of that. I think that message really resonated with our client base first and foremost. But yeah, today, high net worth, pension plans, sovereign wealth funds, kind of all clients across the board.

Kumar Panja: Yeah. And you mentioned earlier the coming together of two pretty big businesses, the private bank and asset management and the hedge fund expertise there. Talk us through that because that has been something which certainly our client base have been talking about, asking us questions about.

Paul Zummo: Sure. It's really exciting and it obviously gets us to a different asset base. I think that higher asset base is hopeful in terms of the way we partner with clients and the way we partner with hedge funds as well. So we could be, I think, a better partner to hedge funds in helping them solve their needs at the size that we are today, where maybe at a smaller size you couldn't be. For us, it gives us access to broader markets as well on the client side. You could just, everything else equal, cover more ground because you have more people, you're seeing obviously all strategies, all managers. So far it's been great and really encouraged by it.

Kumar Panja: And should managers think about the combined group differently?

Paul Zummo: Well, the business model on the private bank side is a little different, right? I mean, it's a single manager distribution, so the types of things that we're looking for, there's nuances on one side versus the other, but effectively we potentially have a home for any and all, from large established managers to early stage managers. As you know, we've always leaned into investing in early stage managers, including day one, and that's certainly not changing.

Kumar Panja: Right, okay. So good news for any listeners who are managers thinking about, yeah, what do the changes mean for them? Okay. Can I pick your brain then on those insights that you and the team could have gleaned over the last 30 years? And effectively some of these are sort of do's and don'ts from a portfolio perspective when you're trying to put together a hedge fund portfolio, and then some of these are do's and don'ts for hedge fund managers, and they're very interesting. So let's start with some tips for selecting a manager in your portfolio. One of the things you mentioned is be a skeptic, be very skeptical. How do you do that and then get comfortable?

Paul Zummo: Yeah, so you're referring to the pearls of wisdom, the paper, right? And yeah, I think it's, honestly, when I think about assembling a team, it's actually assembling a team of people who naturally are kind of skeptic, some of which are skeptics and some of which are optimists. You don't want all skeptics, you're gonna be in cash. So you kind of need a blend, and probably the person who's leading the effort should be a skeptic, it's me. Glass is half empty and probably has a large crack in it as well, you know? And then obviously if you have a head of risk management, it's quite helpful for that person to be a skeptic as well. But there's a mix. I think it's kept us out of trouble over the years especially if you go back 20 years ago, arguably more issues in the marketplace, but it's always important. We approach due diligence from the standpoint of like, where does this break, right? And you're not buying it just for today, but you're buying it for the next hopefully 10, 20 years. And you're underwriting the manager with an eye toward, in a very detailed level, like what are you buying? How does that change in different performance scenarios, different asset under management growth, and like, can you live with that? And how does that offering change kind of throughout that? So it's kind of the way we're underwriting due diligence, but yeah, we're really approaching it from the standpoint of, you know, what has gone wrong with this strategy in the past? What could go wrong with this manager? What are the weak spots? And kind of digging into that. And it's not that you can mitigate every risk in a manager, you can't, but you could certainly underwrite those risks to, you know, have a deep appreciation for it, size it correctly, and then be more attentive probably to the development of that over time.

Kumar Panja: One of the other insights, I think, or things that we were talking about was, don't be afraid to run into fires. And, you know, now this current investing period is a great example of, there are some good opportunities, but it is volatile in terms of NAVs moving around. What do you mean by, don't be afraid to run into fires?

Paul Zummo: Yeah, there's a couple of pearls that kind of speak to similar points, maybe from different perspectives. Like on that one, I actually had, so someone that we invest, since day one is David Tepper. And I always think, I mean, there's a number of reasons why he's a great investor. I think one of which was, when there are periods of dislocation, I think he's shown an ability, obviously not in a reckless way, but in a thoughtful way to be able to run into fires, so to speak, to come out rescuing the people from the fire. He's done very well on capitalizing on some of that dislocation, for sure. And I think it's important. Human nature is such that it doesn't make the vast majority of us naturally good investors. And yeah, when there's dislocation, again, you can't just buy it blindly, but your instinct has to be where are the opportunities? How do I buy this dislocation in a thoughtful, structured way?

Kumar Panja: And then another one you mentioned there in terms of the portfolio is, it's only a great investment if you can hold it. Is that a reference to making sure the manager has good counterparty relationships in terms of access to balance sheets, financing, credit lines, in terms of stress?

Paul Zummo: Yeah, and I think it's a similar one, the great philosopher Mike Tyson says, talks about getting punched in the face, right? And so it's kind of from two different perspectives. Yeah, one, it is from the manager's perspective. And as I mentioned earlier, I think one of the best lessons learned over the decade is just a markedly increased awareness for risk management, financing and counterparty risk, for sure. Certainly more sophisticated today than it's ever been. And yeah, there's obviously many a manager who held smart would be profitable positions that became unprofitable because you can't hold them. We all know the story. So yeah, having great counterparties and financing agreements and partners like J.P. Morgan, certainly extremely helpful. On the Mike Tyson one, really kind of what I had in mind there, it's more, I think allocators will look at a track record or look at a SIM and say, I could live with that, right? So maybe it's someone who's compounding at like 13% a year just to pick a number and operating at a 10 to 15 vol and they have a 20% drawdown, which is statistically, you know, normal, right? And they look at that on paper and they say, I could live with that to get to a 13% return. And I think what they underestimate sometimes is it's one thing to live with something on paper. It's another thing to live with it in real life. And in real life that plays out so much slower than what you think it does.

Kumar Panja: And as you say, so sometimes it plays out in multiple line items that you've got to just compounds the issue when you're an investor because it happens across the book. That segues quite nicely into then the importance of the preparation before you go into manager, so-called due diligence, because that becomes super important. So the numbers tell you one thing, and they might point to a very compelling investment. But then comes the, but how is this business going to react? Or how do we think they're going to react? And so, you know, how important are references in that process? Because you've got the hard data and the references can be somewhat soft.

Paul Zummo: References are always critically important to us. And I think not just important, I would suggest that in the allocators community, not that people don't do them, but the weight that people assign to them or the number of references that they do is underappreciated. And, you know, who should they be doing reference with? Certainly Capintro, always a great source, obviously past employees, you know, people know them, but you really need to triangulate all information on the person and the firm, and you could just glean tremendous insight from that. When you're doing due diligence, you're going in and sitting down with managers and analysts. I mean, obviously that's critically important and you're logging in, whatever it is, you know, 20, 30 hours of time, that's great. But like, there's no replacement to touch base with a number of people who have actually sat side by side with the individual or portfolio manager for 10 years. They have the answer. The truth is out there.

Kumar Panja: And if I may, an extension of that then is culture, the culture of the manager that you are looking at and reviewing. And culture is a very difficult thing to monitor and assess and then put a score on. So how do you put a metric on culture?

Paul Zummo: Yeah, I mean, I don't know that we're, we're not coming up with a quantitative score, but it's important to understand how organizations change

Kumar Panja: You feel good about it.

Paul Zummo: And how organizations are functioning as well. And you're right, it's softer, but you definitely get that through references to ex-employees and you get that just by questions that you're asking. Like sometimes, investor relations people perhaps are confused if we're meeting with multiple people and sometimes we'll ask them like the same question, right? So we'll ask a portfolio manager a question, ask two analysts the same question. And it's to get at a little bit culture and is there an alignment, and how they're thinking. It's not really the same  question, but it's to get at different angles on it. It's important and it's important as to when firms change as well. So there's another pearl of wisdom that talks about success being a dangerous thing. That kind of relates to is that just firms evolve, firms change. Culture hopefully doesn't change, but could change. And the idea there is just, we've seen so many times firms moving from, or portfolio manager, changing from being a great manager of a portfolio to a manager of people. And it's not the same thing. The hedge fund graveyard has a large section of funds that no longer exists from people giving out too much discretion to too many analysts, no longer being on top of positions in a way that they were. So, that's part of the success is a dangerous thing.

Kumar Panja: Yeah. And actually on that, Paul, it's probably worth maybe just pausing and saying, sometimes you will have a manager that has done very well for the portfolio. And then for whatever reason, it's not what it used to be. Strategy, the asset classes invested in, it could be culture, as you just mentioned. What's the exit process? How do you think about keeping the portfolio fresh then? Because sometimes you will need to recycle capital. It's a difficult thing to do, I guess, but there is a hard decision to make.

Paul Zummo: Yeah. I’m certainly open-minded to a manager evolving. I mean, it depends on, and we want managers to evolve in, in terms of their edge has to evolve. It's a matter of degree. So yeah, there are definitely managers that we remain invested as they develop other points of edge. So it's not necessarily a negative. But yeah, I mean, the way we look at, like maybe manager turnover is, I mean, we try to have very long-term relationships with managers. I think the average is about 10 years. There's been people we're invested with for 20 or 30 years. So ideally we're invested with people forever, but the world changed, people's ability to continue to have the edge changes. So yeah, there are times when you're obviously gonna move capital out and you're refreshing that by adding to new managers each year. Some of those could be larger managers, more established, many of them are smaller managers. Again, we are a prominent day one investor in many strategies, especially things like quant. That's been really helpful for us from a number of perspectives.

Kumar Panja: You've always been associated with new managers, how important is the new manager space to the program?

Paul Zummo: Yeah, extremely, and it was never done with 20, 30 years forward, this is going to be important from a business standpoint. It was really just under the desire to cast a wide net, so it was 30 years ago, we would have said that there's, it's alpha out there, it's material, but you have to look far and wide to find the best and brightest, right? So we look across every different strategy, every different manager type, every different size of managers. And yeah, we would find that you would find a great upside downside in a sense from investing with early stage managers, and locking capacity, developing a deeper relationship and maybe a deeper knowledge of that manager. And even if they had bridges across and things to learn, your understanding of that manager would be, again, much deeper than if you came in later. So oftentimes you would find the inflection point in when the business, you know, and the investment strategy was really hitting its stride and then make better allocation decisions at that point. It's always been important. If you look at our emerging managers, they've outperformed the rest of the complex over 30 years and pretty consistently as well.

Kumar Panja: And you're not bound by any particular kind of strategy or strategic asset allocation type process.

Paul Zummo: So I'd say yes and no. Yeah, conceptually, yes. But like the reality is, you know, today clients use us more and more for uncorrelated solutions for a number of reasons. I mean, I think one, today's world, that's what clients need in their portfolio. And in other cases, clients maybe are looking after certain strategies themselves and need us to complete their portfolio through uncorrelated investments or emerging managers or things like that. So a lot of that tends to be in the uncorrelated space, but it could be anywhere. You know, we are still making like a $5 million investment if need be. Hopefully more, but if we want to start an early stage relationship with someone, we think $5 million is the right number, we'll write a $5 million check. Like, so despite being as large as we are, we still want to be flexible in terms of finding the right path to develop relationships.

Kumar Panja: Yeah, and just on that uncorrelated piece, that's, I suppose that's why quant and systematic investing has been such a big part of, A, the historic success, but also almost one of the aspects that from an outsider looking in is a key differentiator for the program and the team's quant expertise. How is any of the things that we talked about or your assessment of quant funds different to any other strategy?

Paul Zummo: Yeah, I mean, there are elements that are the same. It's certainly elements. If not different, it's more complicated, right? Obviously, if you're underwriting a long-shot equity manager, not that it's complicated.

Kumar Panja: There's more IP, there's machinery, the plant machinery become more important.

Paul Zummo: So yeah so on the quant side, we've broken down due diligence across 200 different topics. And not that we're giving anyone a questionnaire, but like in a very structured way, thinking about, okay, this is, and that's just on the investment side, it doesn't include business or ODD or anything else. Thinking about it in a very structured way and the choices that, you know, managers make, everything from, you know, obviously, you know, the data and ton of questions around data, alpha forecasting approach, optimization, like, so on and just on a very, very detailed way to assess where is the manager's edge? How are they looking to evolve? What are the choices they've made? What are the sophistication of how they're thinking about things? So it's probably more similar than different in a top line view, but the nuance associated with it is, you know, vastly different, obviously.

Kumar Panja: Yeah, and our observation is, certainly in the capital advisory group, that the competition for managers, particularly new managers in the quant space, has gone sort of unprecedented proportions, partly because the costs of setting up these businesses and the teams around it has increased over time. But the sources of capital chasing these opportunities has increased. And here, I'm sort of referring a little bit to the other big platform, multi-strat businesses who are growing their businesses, as well as the traditional early stage investors. How do you work in that environment where it's just become much more competitive?

Paul Zummo: Yeah, I mean, I guess every aspect of the world has become more competitive in some ways. So you gotta figure it out, right? I think it, yeah, the competition for quant is high, for sure, with respect to the multi-strats taking on quant talent. I mean, that will happen for sure, but I think there's a large amount of quant managers that maybe don't want to go in-house to a multi-strat or potentially don't even want, you know, money from it. So I think there's like different people have different preferences and there's kind of room for all. In the quant space, since they don't have infinite capacity, you have to be there early, it's a little more reason to embrace early stage investing. But I think it's an area where you kind of can't be a tourist? So I know other allocators are looking at quant. I think it's very difficult to front early stage quant as someone that is, you know, doesn't have a 30 year experience. Looking out the space isn't deeply networked, which is really important. Like you can't necessarily wait for year five, right? So you have to be extremely deeply networked to find those managers early. Obviously Capintro will play a part in that, but not through a blast email, through deeper personal relationships. You really have to understand like, where are people sitting before they even leave? Or individual groups, where are they sitting before they leave to be able to, you know, stand at the ready in case someone is looking for a change. So yeah, you have to really, I'd say commit in a way that maybe you don't in other strategies.

Kumar Panja: Yeah, okay. So with all this kind of said, and all we've talked about, what advice do you have for managers on how best to present? They've got their first meeting with you or someone in your team. What advice would you give the managers?

Paul Zummo: Well, I'm actually thinking back to, again, something from the paper that talks about, if you don't understand your edge, you don't know if you're above the bar. And I kind of think it's that. There's a million points of advice you give to a manager, but-

Kumar Panja: Self-awareness points.

Paul Zummo: Self-awareness, where sometimes people, they need to know like their place in the strategy in which they sit and really have a deeper appreciation of their edge. And then obviously lean in, if it really is an edge, kind of lean into that and prove it. And if it's not, it's a different conversation. But like, it's a self-awareness of people, of like, we're very good in these areas. We're leaning into these areas. We want to further develop that. So it's a thoughtfulness and an awareness that comes through those conversations.

Kumar Panja: Well, Paul, many congratulations on your Pearl anniversary. Thank you for sharing your insights. Obviously we're part of the same J.P. Morgan family, so we're very invested in your success as well. But this has been great. Thank you very much for your time.

Paul Zummo: Thank you. I really, really appreciate the questions and the support and partnership over the years.

Kumar Panja: Great, thank you. And to our listeners, thank you for listening. Stay tuned for the next Capital Advisory Podcast. Stay well.

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