The Hedgeweek Interview: Ian Cadby, Ermitage Group: Building on strong relationships in Japan

Ian Cadby outlines Ermitage's manager selection process and outlines the strategy of its Japan Absolute Fund.

Ian Cadby is the Group's Chief Executive Officer, Chief Investment Officer and Chairman of the Investment Management Committee (IMC). Ian joined Liberty Ermitage (now called 'Ermitage' since an MBO earlier this year) in January 2001 and has extensive experience as a Hedge Fund Manager specialising in Asian equity arbitrage and equity option trading. As a senior equity warrant trader he helped to co-found Cresvale International Asset Management Limited in 1990, an Asian equity hedge fund business, headquartered in London. In 1993 he was posted to Hong Kong as Managing Director of their Hong Kong Asset Management business.

Whilst in Asia he also worked for Citibank as Vice President in their structured derivatives business and finally at Regent Pacific Group in Hong Kong, where he was Head of Hedge Fund Trading. Whilst at Regent, one of the hedge funds he managed, 'Discover Asia', gained the Lipper Award for 'Best Performing Asian Equity Fund'. After leaving Asia, he co-founded a London-based Asian hedge fund business, which was one of the best performing funds in its sector for the year 2000. For several years, Ian was a registered Commodity Trading Adviser, and is currently a Member of the Securities & Investment Institute.

HW: What is the background to Ermitage?

IC: Following our first hedge fund investment in 1984, the Group has grown impressively to manage assets in excess of USD 4 billion and provides a comprehensive service including funds of hedge funds, managed accounts and bespoke solutions.

We launched the Japan Absolute Fund back in April 2002, as we saw considerable opportunity in the market to generate good risk adjusted returns via the long/short strategy. At the time the market was trending downward and there was not a great deal of interest in Japan in general. This did however allow us to establish strong relationships with existing managers, while they were still open! It also allowed us to develop a deep understanding of the market. As the market has grown and new funds and strategies have been launched we have been able to expand our portfolio and continue to establish strong ties with new managers.

As of January 2006, Ermitage is managing assets in excess of USD 195 million USD across our Japan Absolute Fund and a segregated Japanese account.

HW: Have there been any recent events such as launches or changes/additions to the management team?

IC: As of 1st June 2005, we added a new research unit, controlled by Mark Hucker (Chief Operating Officer), to independently perform and oversee operational due diligence.

In April 2005 we launched an additional global multi-strategy fund of hedge funds - the Classic Reserve Fund - which is an innovative product offering investors access to a selection of underlying managers, all of which are closed to new subscriptions or where applications are restricted.

In 2005 we further re-structured our gold-based fund, re-naming it the (Liberty) Ermitage Resources Fund. The Fund, which invests principally in resource and other commodity related funds, provides an additional diversification vehicle for investors.

HW: What is your investment process?

IC: The first stage of our investment process is built upon our sophisticated proprietary database of hedge fund managers - called 'LEWIS' - within which our strategy analysts apply a series of quantitative filters and identify out/underperformance within each investment theme. In stage two, a robust programme of qualitative research is undertaken that includes manager visits and interviews; currently, we have detailed qualitative profiles for 550 managers globally. During the third stage, we apply further selection criteria to create an approved list of approximately 180 managers. Stage four is our portfolio construction phase, when we select managers from our approved list to construct our final portfolios.

On a monthly basis the Investment Management Committee ('IMC') meets to consider the detailed appraisal of performance and outlook by our strategy specialists, who have a frequent dialogue with approved hedge fund managers, to define where performance has come from and where we will find it. The IMC analyse projected macro-economic and market indicators and themes, discuss the influence of equity and interest rate scenarios, coupled with the outlook for other hedge fund related factors such as volatility and credit spreads, to formulate the 'house' top down view. We then test and adjust strategy allocation for risk factors against perceived scenarios. With the benefit of deep statistical modelling, we select strategy weightings and agree allocation to managers from the approved lists to achieve the desired strategy allocation, focused on likely opportunities. The portfolio construction team then uses sophisticated analytical tools to construct and stress test the portfolios to ensure that the asset allocation is reflected across the whole range of Ermitage investment solutions.

HW: How has your fund performed?

IC: The Japan Absolute Fund has generated strong absolute returns since inception - almost matching the return of the buoyant MSCI Japan Total Return index - though with only around one third of the risk.

The Japan Absolute Fund (B Class USD) has delivered an average return of 10.97% since its inception in 2002, with 2005 performance at 21.73%.

2005 YTD return: 21.73%
Average Annual Return (since inception): 10.97%
Standard Deviation: 6.13

HW: How many funds are in your portfolio?

IC: We started 2006 with 18 funds in our Japan long/short portfolio.

With approximately 140 Japanese hedge funds in existence today, it is now possible to diversify by a number of criteria: These include, market capitalisation, market exposure, manager location and manager style. The benefit to the fund of funds manager is that he is able to construct a diversified portfolio of funds which generate their returns from a variety of different opportunities.

HW: What makes a manager special enough for you to select him?

IC: The long/short talent pool in Japan is smaller than in the US and Europe, which is partially a function of a less mature market place for hedge funds but also the result of a 15 year equity bear market which reduced the number of active manager focused in the region. As capacity with the most talented managers' remains tight, it is important to have established relationships with these managers and also be prepared to build relationships early to secure capacity going forward.

To make our approved list, a manager has in essence to prove they have a i) Sustainable edge ii) Integrity and iii) Transparency.

Qualitative assessments are based on a function of:

  • Manager strategy or sub strategy
  • Source of ideas
  • Clarity of trading insight
  • Cyclicality
  • Correlation
  • Competitive edge
  • Performance and attribution analysis
  • Transparency.

Quantitative performance measures important in assessing a hedge fund manager's track record are:

  • Return
  • Length of track record
  • Standard deviation
  • Volatility
  • Sharpe ratio
  • Sortino ratio
  • Maximum drawdown
  • Peer comparison
  • Profit attribution.

We are greatly assisted by our in-house proprietary hedge fund database system - 'LEWIS' - that currently tracks more than 4000 managers. Our strategy analysts have sub-divided the manager universe into strategy peer groups, which facilitates targeted search functions and allows each analyst to work with a filtered shortlist of managers per strategy. Through the system we are able to highlight and track new managers (globally) entering the universe and to conduct detailed peer group analysis of them. In addition, we are able to spot outliers using our 'heat-mapping' technology, which is linked in to LEWIS and enables us to interrogate the database using multiple search criteria.

HW: What are your criteria for removing managers from the fund?

IC: We constantly review the managers on our invested and approved lists against the Quantitative & Qualitative criteria highlighted earlier. Issues such as poor performance, erratic risk control, style drift, high staff turnover, lack of access to key staff, insufficient balance sheet, inadequate reporting and reduced transparency are always in the forefront of our minds, and are monitored and highlighted when they occur. In practice, we would always expect to redeem from an existing manager should they refuse us the transparency we require or if a key portfolio manager leaves.

HW: How many managers do you have on the substitute's bench?

IC: Following recent subscriptions to our Japan Absolute Fund, we have just allocated funds for the first time to two of the managers in reserve on our Japan 'approved list'. As a consequence of our analyst's visit to Japan in November, we have identified three further managers who have been added to our approved list in December, having successfully passed our extensive due diligence checks.

HW: What events do you expect to see in your sector in the year ahead?

IC: On balance the picture for Japanese market direction is encouraging if not clear cut. We believe that there is significant scope for further opportunities in the region, as the market has yet to see the same level of local investment as it had from abroad, as much of the recent buying by foreigners with domestic institutions remaining net sellers.

Of course financial markets seldom travel in a straight line and the very fact that Japan seems to be such a consensus trade amongst most non-Japanese investors is a cause for concern, at least in the short-term. Whilst much of the attention of the Q4 rally has centered on domestic related sectors, the Japanese economy, perhaps more so than most, is tied to the global cycle and US consumer spending. Although the Japanese equity market has been able to decouple from other equity markets in the recent past, the key risk to the economy is a global slowdown. Connected to this, China is now a much bigger influence on the Japanese economy - both as a trading partner and also for many Japanese companies that source materials or produce goods there. With some commentators pointing to rising geopolitical tensions, any instability in the relationship with China would feed through directly to Japan.

On a global level, markets are continuing to prove to be extremely resilient with underlying valuations in the equity markets remaining strong despite the continually overhanging fears concerning the US economy. In terms of interest rates, we anticipate that 2006 would prove to be a 'ticking up' year with US interest rates leveling off at between 4% and 5%.

HW: How will these changes/future events impact on your own portfolios?

IC: One of the features of the Japanese market over the last 20 years or so has been its propensity to move sharply up and down offering opportunities to those who can manage their market exposure actively. In the event of future volatility in Japanese equities, we believe that a product which can participate in rising markets and protect returns from downside risk looking to compound gains through time, is an effective approach to investing in Japan. This is one of the features of Japanese Fund of Hedge Funds, where market adjustments can cause 'dislocations' in relative values that create trading opportunities for Hedge Funds. The very strong directional move up in 2005 led to sector re-ratings en masse and there was less focus on relative valuations between stocks within these sectors. We anticipate that stock selection skills will be even more important in 2006, as attention is focused on what is happening at the company level. Again this plays into the hands of those targeting returns through alpha rather than beta.

HW: What differentiates you from other managers in your sector?

IC: On a specific level, because the Japan Absolute Fund was launched back in April 2002, we have a 3 year+ performance track record, strong relationships with a hand-picked portfolio of managers, together with a real insight into which managers can deliver alpha in the long/short space.

On a more general level, Ermitage is totally focused on providing clients with access to absolute investment talent, from the research team responsible for each hedge fund strategy - through to the managers we meticulously select within each portfolio.
 
The Group's 16-strong research and investment team consists of several former hedge fund managers and traders. Three of these ex-hedge fund traders have collectively over thirty year's experience of trading Japan from both a long/short and arbitrage perspective. At the heart of our business are state-of-the-art software and proprietary systems, which allow the investment team to efficiently integrate qualitative and quantitative inputs into our risk-adjusted portfolios, ensuring they dynamically reflect the Group's strategy outlooks.

We have been managing hedge fund money for 20 years and have built up long-term relationships with the single manager community. Added to this, we have a strong institutional infrastructure, yet we still are of a size where we can allocate money efficiently.

In addition to our comprehensive range of Fund of Hedge Funds, we have demonstrated a talent and willingness to provide more individual risk-return mandates, in terms of bespoke solutions and managed accounts: As an example of this we operate a $100m+ Japanese long/short segregated mandate.

HW: Some funds of funds have complained that managers are not taking enough risks in the current environment - what are your views on this and on risk in general?

IC: The objective of our Japanese long/short equity portfolio is to generate superior returns that will contribute to consistent performance with low volatility over time. With this backdrop, we are satisfied that our risk-return budgeting for the fund is consistent with investor requirements. We have been able to construct a diversified portfolio of funds, which generate their returns from a variety of different opportunities. As alpha is being captured from different often unconnected sources, this reduces considerably the volatility of returns of the overall portfolio and helps to protect against overall market volatility. During 2005 we have witnessed increased volatility and volumes in the Japanese market, which has created a larger number of liquid opportunities. In general, this has translated into managers increasing their gross exposures. We therefore don't currently feel that Japanese long/short managers are taking insufficient risk however it is incumbent upon us to ensure that we are comfortable with the level of risk being taken at the individual manager level.

HW: Are investors' expectations moving upwards and how do you deal with this?

IC: As 2006 begins we are anticipating an improving investment environment for many arbitrage and directional strategies - which investors no doubt will hope can translate into to a higher level of absolute returns in the months ahead. In our discussions with investors we are mindful to balance our house views on projected returns with the historical performance our funds have delivered, drawing particular attention to their medium to long-term investment profile.

With regards to Japan, we expect opportunities to generate alpha to remain high and if anything to increase in 2006. We have started to see an increase in corporate activity and more of a focus amongst Japanese management on shareholder value. We would expect this to translate into more stock specific opportunities i.e. an increase in the number of winners and losers lending itself to a long/short strategy.

HW: Are you planning any further launches this year?

IC: Ermitage has a programme of new product development designed to meet evolving investor demands, and have a number of new launches in the advanced planning stage. One of the new funds we believe will have strong investor appeal is a pan-Asian long/short fund of hedge funds.

(Ian Cadby was interviewed on 13 February 2006

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