5. A dynamic approach to hedge funds allocation; André Pierre Visser, CIO, and Jan Pensaert, CEO, La Fayette Investment Management
With over USD 1 billion in assets under management, La Fayette Investment Management is one of <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />London's leading fund of hedge funds companies. La Fayette's founder and CIO André Pierre Visser and CEO Jan Pensaert discuss the company's investment philosophy.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
HW: What is the background to La Fayette?
APV: I founded the business in Paris in 1992 with USD 5 million in assets managed in one pool for friends and family so they could all benefit from the same performance. I was quick to realize that having money managed via alternatives de-correlated to the market presented significant advantages.
This was proved when we quickly raised assets under management with a USD 1 million mandate from a bank and other orders from institutions followed. It is interesting to note that almost all those investors are still with us and have increased their allocations over the years.
We moved the business to the UK in 1997 when we had around USD 100 million under management. The hedge funds market with all the related information flow was much more concentrated in London. Also, the legal infrastructure was, and still is, much better and more straightforward in the UK than in France.
La Fayette's manager universe has grown organically over time, since contacts we had initially with managers such as Tudor, Soros, Tiger etc have expanded into a large number of new contacts derived from the same original 'family' of hedge fund managers, with whom we continue to have strong relationships.
These relationships, coupled with La Fayette's strong track record are key factors behind our growth and provide us with a strong competitive advantage. Today if you want to start up a fund of hedge funds you have to survey a universe of some five or six thousand hedge funds, but without established inter-personal relationships it is very difficult to create and sustain a track record that will attract investment.
HW: What is the structure of La Fayette?
APV: La Fayette is wholly owned by management. It is clearly very important to be independent. This means we have no constraints in terms of reporting upwards to other entities and we can be totally unbiased in our judgement.
HW: Does your independence also present a weakness in terms of not having the backing and resources of a large institution or a bank?
JP: It is a matter of professional approach. We have successfully demonstrated to investors that La Fayette's approach to investing is well considered with a serious focus on risk management that is applied not just at the level of our portfolios, but also in the analysis of the underlying hedge funds that we invest in. Combine this with La Fayette's relationships and track record and one does not necessarily need a huge statistical or quantitative team in order to be able to set up a very efficient and stable approach to investing.
Moreover, we find increasing opportunities within the hedge fund universe to outsource to external professional parties those functions where we do not add much value, such as administration, and certain aspects of data collection, risk monitoring, compliance and IT. In terms of La Fayette's investment approach, we are also investing more and more with managers that have sound administration and risk management procedures in place - the overall efficiency is much enhanced by the institutionalisation and professionalism of the intermediaries in the sector.
This lean approach is validated by the fact that 85% of La Fayette investors are institutions which generally allocate to much larger groups, with a much larger cost base.
HW: What are your products?
APV: We have three principal funds of funds, each of them available in USD and in Euros.
The first product is La Fayette Holdings, a fund of hedge funds that has a compound rate of return since inception in 1992 of 14.9%. It is invested in about 40 positions covering all hedge areas on a global basis: equity long/short; global macro/futures; relative value/event driven; and, special situations.
The second portfolio is called La Fayette Europe. It was launched in 1996 and is invested in the same hedge strategies globally as La Fayette Holdings, with the caveat that all its managers are located in Europe. It has about 35 positions and its annual rate of return since inception is 20.4%
The last portfolio is La Fayette Regular Growth, an arbitrage fund of hedge funds. With only five down months in the last sixty, this is a low volatility product that intrinsically aims at showing very stable and consistent returns. It has 35 positions in a very diversified number of themes in the portfolio and comprises uniquely relative value trades, including fixed income arbitrage/futures; convertible bond arbitrage; statistical/pairs trading/merger arbitrage; multi-strategy; distressed/high yield/ credit arbitrage, and Reg. D managers.
HW: What is your asset allocation process?
APV: It is called Dynamic Asset Allocation. La Fayette's basic premise is that we want to build our portfolios with asset managers that are the best in their field, and we continually make marginal changes to enhance the quality of our portfolio.
We want to have the best possible portfolio at all times, and rather than having a portfolio of ten of the best managers that we slavishly hold for ten years, we monitor the managers constantly and if we think that the quality and stability of a particular manager is increasing we will increase our allocation - we do the reverse if we feel quality and stability are decreasing.
Companies that were big names in the hedge funds market a few years ago such as Tiger, Steinhardt or Lazard are not big names today. The dynamic in this business, which many people underestimate, is that very successful people will gather assets quickly and then close their funds to new investment. So we need to be quick not only to take advantage of these opportunities, but to reallocate if their performance starts to fade.
HW: How frequently do you reallocate the portfolios?
JP: We have a monthly investment committee meeting. This is our opportunity to formally review the composition of the portfolio, reflect our anticipation of any macro and market evolutions in terms of those portfolios, and finally to conduct the firing and hiring of managers.
HW: What are your key reasons for hiring/firing managers?
APV: There are three key reasons for changes in allocation to managers or strategies.
First, to reflect macro economic and market conditions we allocate to alpha generators with the optimal risk/reward ratio and we reduce or remove obsolete strategies.
Second, we place strong emphasis on inter-personal aspects that may affect a fund, such as changes in the personal environment of the managers, team changes and the 'fat cat' syndrome, where managers simply lose the incentive to perform.
Finally, we consider a set of risk management factors, including aggregate direction/exposure in underlying strategies, leverage/sector/geographical risk and the level of correlation.
HW: How many managers do you have on the substitutes' bench?
JP: We continuously have a group of between 20-25 managers that we consider adding to the portfolios - provided they meet our various requirements - to help fine-tune and enhance these portfolios.
For example, in the case of La Fayette Holdings, in early January 2000 we were concentrated in directional strategies and participated in a major way in those strategies Since then market turbulence has made us continually rebalance the portfolio every month to a currently much more diversified allocation between strategies and also between the number of managers. The number of managers now, at around 40, is much larger than in 2000 simply because the absence of clear trends makes us want to have less concentration and less exposure to managers having to take directional bets in this portfolio.
HW: Does this high level of diversification reflect uncertainty in the current environment?
JP: Yes it does. Based on our conversations with managers, and on our market view, we feel that these are very uncertain times and we prefer not to be dragged into a position where we would need to make significant readjustment if and when the markets take a different direction next year.
We currently prefer to have a stable portfolio and participate more by adding some leverage at the fund of funds level rather than take directions in underlying strategies. La Fayette's portfolios are well-protected but also well-positioned so that when we see a reappearance of trends that are clear, persistent and identifiable, we will be able to participate in those.
HW: What trends do you anticipate in 2004?
JP: If you look at the composition of La Fayette's portfolios it is clear that we try to not depend on a direction right now. On the other hand we identify niche strategies that may appear rather opportunistic now but that may well develop into successful and persistent strategies, even in times of erratic volatility. One example of this would be event driven and distressed strategies. Distressed has been very much a symptom of the last 2-3 years and has generated opportunities for a growing range of managers to participate. We see that now there are a number of managers taking this strategy to the next level, which is a recovery story and more of an equity play rather than distressed debt. There are already some managers in this recovery sector producing returns in excess of 50% per year. If this universe and the strategies within it prove persistent, it may well become one of the sub-strategies in La Fayette portfolios in 2004.
HW: Does this example also imply that some managers are now switching strategies to take advantage of related opportunities?
APV: Yes, this ability for hedge management companies to take their model and adapt it to new strategies is a relatively new trend in the hedge fund sector simply because their organizational setup and team building efforts provide them with the opportunity to do so.
Instead of funds and managers disappearing, there is now a more institutionalised approach to investing within hedge funds and boutiques and they are trying to develop a business model.
HW: Some funds of funds have complained that managers are not taking enough risks in the current environment - what are your views on this?
APV: I think this tendency to limit risk-taking and play safe is very good because taking a directional view is very risky today. For example in the fixed income market, interest rates are probably going to rise but if the US economy fails to perform to expectations the reverse may very well be true. Circumstances have changed a lot from the time that interest rates were very high and then started to fall through a series of Fed rate reductions. This trend has now disappeared and being long or short in the fixed income market would be very dangerous now. It is more opportunistic fixed income trading that will be rewarded in the short term and it is rather difficult to take on additional risk.
In convertible bonds as well, most managers are currently taking low leverage of around 2/3 times where they used to be 5/6 times leveraged. We see the same trend in equity long/short where those managers that are doing well have relatively low gross and net market exposures and are trading oriented. Those that have a high gross market exposure are clearly taking a lot of risk because markets in the US appear expensive.
HW: What makes a hedge fund manager special enough for you to select him?
APV: The strength of character and capacity to build an organisation. We are not looking just for someone who has talent in picking investment opportunities, we are looking for someone who has more than that. We need to be sure that our managers can handle the downside as well as the upside, and for that they require strong risk controls and strong minds. Examples are Louis Bacon and Paul Jones - they started when they were just in their twenties but when talking to them you could immediately feel their strength of intellect and character.
JP: The key is to research as many managers as possible. La Fayette is invested with around 100 managers. We meet between 4-6 managers a day, half of those are new managers and the other half are managers with whom we have already invested.
Of the new managers we see, roughly half come to us via references and the other half are introduced by intermediaries such as capital introduction teams or more mainstream sources of introductions.
There are a large number of factors that we need to take into account when reviewing these managers. They need to be able to perform well through different stages of business growth and through different parts of the economic cycle. As such, they need to be strong investment managers, portfolio managers, risk managers and people managers.
Even if we know that we can only invest with a select group of managers, we still see as many as we can since the majority of managers we see help us form a macro view and reflect this in La Fayette's Dynamic Asset Allocation.
HW: Are investors' expectations moving upwards and how do you deal with this?
APV: Market expectations are generally too high. However, one has to realise that if one makes a 10% return when short term interest rates are 1-2% you still make 8% net - that's not a bad proposition.
The stability of La Fayette's returns, which we have shown over the years, also has real value, not just for private investors but also for insurance companies and endowments that have to match their liabilities with assets that do not fluctuate too much.
At the end of the day, delivering attractive but less volatile returns is more important than chasing returns to meet market expectations.
JP: We are in a situation where, in comparison with our peers, La Fayette is less dependent and less concentrated with certain "star" managers that perform well when markets move in trends, but may run out of steam in between.
It is important to keep in mind that the original theme behind the hedge fund universe was to exploit inefficiencies - talented managers with smart money outsmarting less smart money.
We have no problem finding managers that look for inefficiencies in the markets and we find them on an increasingly global scale. Where the primary source of managers used to be in the US and in Europe, we are now able to much more access talented hedge managers in other geographical areas. One example is Asia, where we now find local managers that are able to exploit inefficiencies in increasingly liquid local markets and at the same time have a hedge approach to investing. That geographical expansion is key for us to continuously keep regenerating opportunities at our fund of funds level.
This is the main reason we have been able to show such robust performance in comparison to our peers, as over the last five years or more, all La Fayette Funds have shown positive and absolute results on a year-to-year basis and we will generally outperform our peers over a 2, 3 or 5 year period.
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