Innovating the Hedge Fund Industry

[With the accelerating rate of the financial industry’s ongoing evolution and new product development, it is interesting to explore how this process of creation and innovation happens. Far from being a mystical process or coming from the realm of scary smart people in R&D departments or initiatives, innovation is more of a human process driven by an open mindset that looks for new approaches and solutions. Any change that makes things better can be an innovation. It also does not necessarily have to be technology driven, but it does have to be client-focused and meet client expectations and needs in order for the solution to be accepted as “innovative”.

To better understand this innovation mindset and an innovative product development approach, we were introduced to the MBX Group – a family office led by successful serial entrepreneur Manoj Bhargava who is behind 5-hour ENERGY and other multibillion-dollar businesses. His efforts have expanded into financial services with MBX Clearing – a proprietary trading group specializing in SPX Options on the CBOE – and launching MBX Hedge Funds owned and managed by MBX Group. They are launching two new funds that are structured to prioritize the investor and challenge the traditional hedge fund structure by charging zero fees to the investor and offering returns that are backstopped with their own capital at work.

The flagship fund they are launching is called the TPlus3 Fund which offers investors a Treasury return, plus 3%. Investors receive fixed-income exposure through T-Bills with an SPX options overlay that generates the 3% plus return. In today’s market with Treasury yields at  approximately 4.3%, the fund offers over 7%. For equity exposure, they are launching the Plus2 Fund which provides investors with equity exposure through the SPY ETF with the same SPX options overlay generating the 2% plus return.

For both funds, MBX provides a 10% investment match, acting as a backstop that secures the plus returns. MBX capital is subordinated to the investor acting as a first loss piece absorbing any losses and offers 60-day liquidity. In a world of fee-based AUM growth and many funds having poor investor-manager alignment, these funds are unique.

We sat down with the Founder and Principal behind MBX Hedge Funds, Manoj Bhargava to better understand how a serial entrepreneur mindset works and how he applied it to building innovative hedge funds.]

Hortz: Not coming from an investment or portfolio manager background, what was your motivation in launching two very innovative hedge funds?

Bhargava: When we started this journey, we had no grand plans to innovate the wealth management industry. We had our own family office and we were not satisfied with investment options that we saw as empty promises. We asked ourselves, can we do better? The purpose was just to have our money invested better and provide us – the investor – with clarity and more certain expectations. When we found out that we could do better, we realized that we could offer our investment strategy to other qualified investors, family offices, etc.

The innovation came from taking a different perspective and taking out the parts of the hedge fund investment structure that we saw as “not good”. In other words, you innovate for the better; you do not innovate for worse. We just wanted to invest well, and then we unintendedly created a business, which is to say, we can do this for other people.

Like many innovations, our hedge fund business was created almost as an accident. It all evolved from asking a question and trying to solve a problem of how do you make this better?

Hortz: How exactly did you go about building and designing your investment products to be innovative? What initial steps did you take?

Bhargava: One of the first things I looked at was that anybody can make money in a good market, except for that bad day which wipes away a meaningful part of your investment. So, I started looking at how do we make money through different markets; up, down, and sideways and have a strategy that can lean in and take advantage of those bad days, in particular. I did not accept the old mantra in the investment world that higher risk equals higher return. I was looking for something unique that offered attractive returns with limited risk.

I was not bound by constraints that restrict traditional fund managers. There was no specific mandate we had to adhere to, no set return hurdle, no bias on where to invest. We were willing to try different things, invest in different asset classes across different markets. We were working with our own capital. We took an entrepreneurial mindset to developing the right investment strategy.  I think all of this worked in our favor.

Early on, we took advantage of dislocations in traditional debt and equity markets and although we had some success, it was not exactly what we were looking for. It was when we began to pivot to options and develop our strategy around index options that we knew we had found something different. What we developed offered us the returns and consistency of returns we wanted, and it was scalable. Similar to a business, we built around it. We set up a formal trading team putting the right risk parameters in place. Two years into it, we established a self-clearing broker dealer, which is not an easy feat for a family office, and today we are one of the largest traders of SPX options in the world.

From there, we were able to develop our funds that we can offer up to outside investors.

Hortz: What specific approach did you have in building your hedge funds that helped you address some of the problems you saw in the wealth management industry?

Bhargava: Like many other industries, the wealth management industry loves to make everything so complicated. On the other hand, I am a student of “simple”. We have an invention shop on our campus called the Obvious Factory where we develop different products, where I say, if you do not get it down to simple, you have not finished yet.

Our key decision overall in addressing the industry was to make everything focused around “simple”. You build around a simple proposition to the customer – offer a clear, stated return and do not lose money. For us that means offering a product where the investor gets paid their return first, and our invested capital acts as a backstop and gets paid last.

Additionally, in our fund, the investor pays no annual fee and no carried interest on profits. I do not like to pay manager fees when I invest so we removed traditional complicated fee structures and prioritized the investor. All of this seems like simple and obvious things to do but is rarely, if ever offered. Similarly, when it comes to liquidity, I do not like to tie up capital. For this reason, our hedge funds are designed to offer the investor good liquidity, 60 days. Again, simple stuff.

This philosophy of keeping it simple is everywhere in our organization, not just our product offering but in the way we fundamentally operate. A good example of this in practice is in our trading. We have a team of six-traders; however, they do not operate independently in silos doing different things. They work as one cohesive unit. They decide on a single trade, together. We have a simple system that says we will make large trades, but they are going to be well thought out and each one runs through our risk models before we execute.

We do not believe in the need for high speed, algorithmic, or technology driven traders, using AI, etc. We use technology as a tool to direct us to the most favorable trades, but people decide and transact. I frequently say to people, I am still looking for real intelligence, not artificial intelligence. It Is important to know what the right questions are. All the algorithms in the world can give you great answers, but if you ask the wrong question, the answers are irrelevant.

Hortz: What would you say are some of your main product differentiators?

Bhargava: Probably the biggest difference in our hedge funds comes from the fact that we are fundamental thinkers while most hedge fund managers tend to be very technical in their thinking. Our specific design decisions helped us address the problems we saw in the asset management industry. One of the biggest is paying large fees regardless of outcome. We structured our hedge products so clients do not have that kind of experience.

It is well understood that hedge funds make most of their money on their industry standard 2% fee. Whether they make any money or not for the client, it does not matter. Hedge funds get their 2% and are then supposed to be responsible for making the client money. That makes no sense to me. From my perspective, your fee should be paid from what you make – if you are any good at it, if you have any confidence. Otherwise, it would be saying in any other profession, like a plumber, give me a thousand dollars and I may fix the leak, I may not, but I want my fee. That is the typical hedge fund approach, which is a great approach for making money for hedge funds, but it is not for the client.

In building a business, I always think from the client side first. I built an investment product, a hedge fund, where I am plainly saying upfront that you are making a profit and what that profit specifically is – which is our stated payment of 3% over T-bills in TPlus3, which we pay the client. I can do that because we are confident, through years of trading and our own expertise, that we can make a profit beyond that, but we put that risk on us, not the client. If there is any shortfall, it is made up by us, not the investor. I know that is unique in Wall Street where targeting returns and delivering returns are two different things. We, on the other hand, give you a specific promise and then we stick with it. We are sort of old-fashioned in that regard.

As in all the businesses I built in different industries, you have to meet the expectations of the client. Do not put out there crazy expectations, alluring return goals, because no matter what, clients are going to be disappointed and going to be mad at you. Then what you have to go through is churn and hope that the client has too much inertia to move their money. You have to admit you had a bad year and you just pray that the client feels that next year will be much better based on the slew of reasons you can provide them with. If I am the client, I would want somebody to put their money where their mouth is. Are you going to stand behind your product or not?

Hortz: How did having a very successful serial entrepreneur mindset help you through this product development and determine how to redefine what investors can expect from hedge funds?

Bhargava: I built three companies that are worth over a billion dollars and in completely different industries. The one thing I have seen consistently is that you go into an industry and all the incumbents say, What do you know about it? What I say is Well, I don’t know a damn thing! And that is my advantage.

It is so easy to come into an industry and see what and how things are being done and then ask Why are you guys doing things this way? And usually, industry players do not have an answer except that is the way they have been doing it for years. And so, you can come in and look at it and go, that does not make any sense.

We approach it from a common-sense point of view. Our investment clients will be Qualified Investors who are more inclined to common sense than they are to the alpha, beta, algorithms, standard deviations, and all the buzzwords that the bigger players love where they need to check all the boxes. We are meant for those who just use common sense. They want a simple product with a stated return and a manager that is willing to put up their own capital: T-bills plus 3%  with a 10% backstop. There are some details to that, but it is really that simple. It is not like Wall Street always making it more complicated or making it seem more complicated. That is not the answer.

Hortz: Can you further explain your backstop feature and how it works?

Bhargava: The backstop is us putting money where our mouth is. We are confident in our ability to execute but if there is a scenario where we underperform, the investor should not be impacted. After all it was not their fault. We as a Manager should absorb that and protect the investor. That is what the backstop is about. It acts as a first loss piece, offering downside protection for the investor. It is what we would want from an Investment Manager who is managing our money.

For our funds, it is established on Day 1 through an investor match. For every dollar the investor puts in, we match 10% of our own capital. That 10% is funded in cash from the beginning and acts as a backstop for the investor. If there are any losses, or shortfalls in achieving stated returns, the backstop is there to absorb that. It is fundamental in what it offers, but it is also critical in what it stands for to our investor, that we are accountable.

Hortz: How would you see that financial advisors and asset allocators can employ these hedge funds in their client portfolios?

Bhargava: The TPlus3 is for those investors looking to increase fixed income returns with zero fees and good liquidity. They want the stable return that fixed income provides but with something that consistently beats inflation. It can be used for something as basic as cash management given the ability to redeem within 60 days but can also be seen as an attractive alternative to some of the more traditional fixed income products out there such as investment grade or high yield bonds. In today’s market our TPlus3 Fund yields over 7% materially beating yields offered in many of those products. In some cases, it can compete against higher yielding private credit funds when fees are netted.

The Plus2 Fund is an equity product. It is for investors looking for enhanced returns within equities again at a zero-fee cost and with good liquidity. It is perfect for investors that are looking to gain exposure to a passive index, such as the S&P 500, but want to beat the market every year. The Plus Return(2%) in our fund acts as the alpha kicker to the underlying index, and through the power of compounding, can add material value over time to investor capital. Again, given its redemption features, it is especially attractive for investors that want flexibility of capital within equity investing.

Both funds can be used as first loss strategies in any portfolio given the backstop. They could also be used as part of interval funds given the attractive liquidity features. We view them as versatile and frankly we are still learning all the ways they can be applied to a broader investment portfolio. In all cases these products are for qualified investors only.

This article was originally published here and is republished on Wealthtender with permission.

About the Author

Bill Hortz

Founder Institute for Innovation Development

Bill Hortz is an independent business consultant and Founder/Dean of the Institute for Innovation Development- a financial services business innovation platform and network. With over 30 years of experience in the financial services industry including expertise in sales/marketing/branding of asset management firms, as well as, creatively restructuring and developing internal/external sales and strategic account departments for 5 major financial firms, including OppenheimerFunds, Neuberger&Berman and Templeton Funds Distributors. His wide ranging experiences have led Bill to a strong belief, passion and advocation for strategic thinking, innovation creation and strategic account management as the nexus of business skills needed to address a business environment challenged by an accelerating rate of change.