Thu, 28/10/2004 - 18:11
André du Plessis discusses a wide range of topical issues and outlines the background and strategies at the USD 9 billion institutional asset manager.
HW: Coronation has been managing funds of hedge funds for pension fund clients since the mid-90s. With this in mind what are your thoughts on allocations to hedge funds by pension funds?
AdP: This is very topical. As we all know institutional interest in hedge funds has continued to increase as expectations for equity and fixed income returns have been falling. Active management and absolute returns have become the new focus and pension funds are increasingly allocating to alternative assets.
Trustees are recognising that the traditional asset-liability model needs to be reassessed. We suggest clear investment objectives which relate directly to fund liabilities in order to set specific risk levels relative to these liabilities and consequently the expected returns.
Institutions are therefore focusing on more efficient asset allocation linked to risk budgeting in order to maximise alpha generating opportunities per unit of capital. We have long argued that the level of active risk in pension fund portfolios is too low and active management can add alpha as differences in fund manager skill and information does exist. Clearly as active risk is uncorrelated to market risk, it can be added to the portfolio without materially increasing overall risk and this separation enables risk to be more efficiently allocated to generate the highest possible risk-adjusted returns.
While plan sponsors and trustees obviously need to take risks, unfortunately in the past this has been predominantly market risk. Higher risk has usually been associated with a higher tracking error, rather than the risk of capital loss and return volatility. In most instances, the fund managers are seen to have achieved their objectives, notwithstanding the deterioration of the fund performance.
HW: What then are your thoughts on asset allocation to hedge funds in general?
AdP: Well, I would suggest that risks should be more broadly allocated amongst asset classes, including for example liability-driven bonds which reflect the fund's liability characteristics but also the use of swaps and low volatility arbitrage hedge funds to separate the active alpha. Furthermore, there may be a need for lower equity levels with higher allocations to the active management element. In my view the latter must be properly incentivised to maximise returns on the assets with measurable alpha but, to do so effectively, should have greater mandate flexibility in order to focus on areas of high conviction but also do so within the context of tight risk controls to minimise capital loss and return volatility.
In a nutshell, we think that an appropriate level of scarce capital should be allocated to passive market exposures through low cost beta-generating vehicles such as index funds, exchange traded funds and derivatives, while the remainder should be put to work in actively managed, absolute return orientated long only, as well as hedge fund strategies which can consistently deliver absolute-plus returns but with high levels of alpha and at a given level of risk. This thinking is also relevant where hedge funds can be used to "port" the active return to overlay assets, given the ability of some hedge funds to consistently deliver attractive LIBOR plus returns with low market correlation.
At this stage we find that many of the defined benefit plans are initially attracted to low volatility hedge funds, often rebalancing their portfolios with a reduction to the fixed income allocation but this is often more of a tactical move based on interest rate expectations. Nonetheless, many pension funds I speak to are considering the approach I have briefly discussed here and are increasingly setting target returns based on a risk-free-rate-plus-basis which we think is the right approach in this environment.
HW: What is the background to Coronation?
AdP: Coronation was started in 1993. I guess the owner/manager culture of Coronation is evident in its genesis. After failing to achieve an equity stake and profit sharing arrangement with their previous institutional employers, almost the entire investment team of fund managers, research analysts and support staff started Coronation Fund Managers.
Today, most of the original founders of the group are still actively involved in managing the assets. In the past ten years Coronation has grown its assets entirely organically, managing both long only and absolute return assets. This has been achieved by focusing exclusively on asset management and on the consistent delivery of superior investment returns. To do so effectively we keep ourselves focused by outsourcing most things, including distribution.
HW: What is the ownership structure?
AdP: The founders, management and staff today own 55% of Coronation Fund Managers. Other major shareholders are Alan Gray Investment Counsel, the owner and manager of the Orbis hedge funds with around USD 2 billion hedge fund assets, and Old Mutual, the FTSE-listed financial institution. Capital International, the major global asset manager based in LA, was previously a large shareholder.
HW: Does your independence and boutique set-up represent a business risk as surely you lack the infrastructure and resources associated with the backing of a large financial institution?
AdP: No, not at all. We value our independence enormously. We believe that our owner-manager culture is very important. We are pretty single minded in our approach to performance and totally unbiased in our judgement. In fact, given the impact of capacity issues on most of the large funds of hedge funds, we believe that our "mid-cap" size is hugely advantageous and provides an optimal investment environment. Quite simply, the group is sufficiently large, well capitalised and profitable to have all the necessary resources and infrastructure, yet is the optimal size to provide an investment focused "hedge fund-like" environment, without business and institutional distractions.
HW: Coronation appears to have a relatively low profile. Why?
AdP: We are comfortable with a lower profile. It is often a surprise to clients to find that we have been managing funds of hedge funds for our pension fund clients since 1996. In fact, in the early nineties, the founders of Coronation Fund Managers successfully managed a hedge fund for one of the great doyens of the industry. We have always had an orientation towards absolute returns and minimising downside volatility in the way we manage money.
HW: What are assets under management at Coronation?
AdP: Coronation manages over USD 9 billion, almost all on behalf of pension funds and other institutions. This includes our first fund of hedge funds, the Coronation Global Equity Fund, which was set up nearly eight years ago in Dublin. This fund has grown steadily since with assets of around USD 550 million today. It has been managed since inception by one of the Coronation founders, Anthony Gibson and has delivered annualised dollar returns of around 12%.
HW: What differentiates Coronation from the crowd?
AdP: The key differentiating factor is undoubtedly the level of direct investment management experience and day to day hands-on involvement of our principal fund managers. They have on average of 15 years investment experience including managing single manager hedge funds, as well as over 7 years managing large funds of hedge funds.
Our CIO Arne Hassel was previously Head of the Goldman Sachs Hedge Fund Strategies Group with responsibility for managing their fund of hedge funds business outside of the US, after heading GSAM's Global Currency Management, which included single hedge fund management. Anthony Gibson has successfully managed large institutional funds for the past 20 years, and funds of hedge funds specifically for 8 of those years. The other senior fund manager is Stuart Davies who has a highly respected track record of over 6 years managing funds of complex arbitrage and event driven strategies and was previously the CIO at NIB, a large funds of hedge funds group.
HW: Could you outline your fund range?
AdP: We have three principal funds which are all sector specialist funds. They cover the entire hedge fund universe, namely a relative value arbitrage/event driven fund, a long/short equity fund and a global macro/tactical trading fund. As you will know, this sector approach is somewhat unusual in this industry where initially most funds of funds have tended to be multi-strategy.
As all our sector funds have track records of over four to eight years, this sector approach provides many attractive portfolio construction opportunities to create client-driven solutions, based on lengthy track records, rather than carve-out pro-formas as is so often the case.
The practical experience of managing specialist funds of hedge funds for pension fund clients helps Coronation to understand some of the real issues involved and various currency overlays are often used, as well as the ability to actively manage the asset allocation by adding or excluding sectors, strategies and styles. In fact, most of the larger investment consultants prefer the sector specialisation approach and agree this is the future direction of institutional investment in funds of hedge funds.
HW: What is your asset allocation process?
AdP: It is a very important part of our process. We believe risk adjusted returns are a function of both the skill of the manager and the investment opportunities within the area in which the manager invests. Our medium-term tactical sector and strategy allocation is primarily focused on the opportunity set of managers in different areas. Our investment team's experience in managing long only and hedge funds as well as researching hedge funds for fund of fund portfolios has given the team a deep understanding of the key drivers across the range of different hedge fund strategies. The investment process incorporates these factors when constructing a portfolio.
HW: And your manager research process?
AdP: This is an enormous subject on its own. But in brief, once we have identified a profitable strategy operating in an attractive opportunity set, our analysis of manager characteristics us to look behind the "labels" of the underlying hedge funds and to analyse what the fund manager really does and the actual sources of returns and nature of risks. This analysis is a vital and extensive part of our risk management process and includes innovative methods to understand the real risks being assumed by managers and the extent to which these are effectively hedged and diversified.
This is where we feel our investment process can truly impart value to the investor: we are able to assess and evaluate the current business cycle in order to proactively position our portfolios to benefit from the current position on the various strategy cycles.
HW: What are your key reasons for hiring/firing managers?
AdP: We believe that the initial research and due diligence process, when intelligently done, rather than just processed, should eliminate most of the non-strategic and tactical changes. Our investment and due diligence processes must always be completed in full and all potential 'no go' areas addressed and concluded.
Manager termination would result from a variety of factors, but is primarily as a result of performance and volatility levels outside our predetermined expectations for that manager, and lack of a satisfactory reason for this deviation. Other important reasons relate to changes of investment strategy, changes to investment process, senior investment team changes, asset size changes, changes in available liquidity, regulatory concerns, changes to basis of instrument pricing and service providers.
HW: How many managers do you have in your portfolios and on the substitutes' bench?
AdP: Our 'buy list', so to speak, consists of about 45 managers across all the different strategies, while we are currently invested in approximately 65 managers across all our funds.
HW: Are members of your investment team specialists or generalists?
AdP: We have a team of 23 in London and the focus is on specialist research skills. We think it will become increasingly important for anyone investing in hedge funds to be able to interpret actual portfolio holdings, including the nature and structure of the hedges which in some strategies are often pretty complex. Without that expertise, it becomes increasingly difficult to assess the relevant skill sets, understand all the risks and construct a well-balanced portfolio.
HW: In short what parts of the investment process will increase in importance?
AdP: We believe that the focus on portfolio construction and views on strategies will increase. In order to generate returns and avoid problems, fund of funds managers have to be able to forecast which areas run the risk of becoming overcrowded and where hedge funds might be taking excessive risks to eke out returns. Another area of increasing importance is the relationship between different strategies and opportunity sets in different market scenarios and what the impact on the portfolio might be.
The bottom line is that we are likely to have to rely increasingly on alpha to meet return objectives and that hedge funds are still the best place to generate good low volatility returns. As the competition for alpha increases, the fund of hedge funds area becomes more complex and the need for specialist skills and deep understanding becomes more vital.
HW: What is your outlook for market returns in general?
AdP: The days of relying on double-digit annual returns from equity markets appear to be over. Valuations are high and money will not be cheaper in the future. The bond market does not provide much comfort either, with yields being close to historical lows and central banks having provided ample liquidity for quite some time. Commodities have already staged an impressive rally, currency managers are struggling in a trendless market and real estate seems to be close to a bubble. Many agree that generating returns in the future will be less easy and that increasingly we will have to depend on finding elusive "alpha" - the out performance of market indices.
HW: Can hedge funds deliver in this environment?
AdP: We still believe that hedge funds are the best place to find alpha and as I said earlier that clients should allocate more risk to this area. Hedge fund guidelines and incentive structures promote the generation of out performance and, as a result, a large part of the investment talent has understandably migrated into this sector. I guess hedge funds simply mean better managers with better opportunities.
HW: What are the challenges going forward?
AdP: The identification and anticipation of profitable opportunity sets for hedge fund strategies is always crucial in delivering performance. We draw on a deep understanding of the factors that drive returns in each of the strategies and a process that analyses the potential impact on returns and risks. A second challenge is to find those few, well hidden, hedge funds that can consistently create alpha at an acceptable level of targeted risk. As markets get more efficient and the traditional opportunity sets shrink, fund management experience will increasingly make the difference.
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