The Hedgeweek Interview: Kevin Boscher, Director-in-Charge and Chief Investment Officer, Collins Stewart Limited: Adding value through asset allocation

Kevin Boscher predicts that increasing geopolitical risks and tightening global liquidity could result in a major market correction in 2006.

Kevin Boscher joined Collins Stewart in May 1996 as Director in Charge of Guernsey Asset Management. Kevin has since been responsible for building a fund of funds business for the Collins Stewart Group, which includes the management of a number of Standard & Poors 'AA' rated and award winning Funds.  In addition to managing the business, Kevin is also specifically responsible for managing the Group's fund of hedge funds and is a Fellow of the Securities Institute. Prior to his role at Collins Stewart, Kevin was the Investment Director for Old Mutual International Limited in Guernsey where his responsibilities included the management and marketing of a specialist range of funds, using the multi-manager methodology.  He also worked at James Capel in Guernsey as Head of Private Client Investment Management and First Chicago. Kevin has considerable experience in the asset management industry, particularly in the areas of asset allocation, multi-manager investing, marketing and hedge funds. Kevin is a regular speaker at Investment conferences and seminars.

HW: What is the background to your funds?

KS: We launched the Absolute Return Plus Funds in February 2001 and initially employed the services of a sub advisor to help us manage the funds.  For a number of reasons, we decided to take the management of the funds in-house towards the end of 2002 and have thus established a three year track record under our own management.  The funds form part of a Guernsey based umbrella fund structure, which also comprises a number other funds combining long-only and hedge fund strategies.

In addition to managing the funds, Collins Stewart Portfolio Management manages individual segregated portfolios for clients on a discretionary basis.  The Absolute Return Plus Funds form a core holding across the majority of our client portfolios and therefore performance of the funds is of paramount importance.

Having established a successful performance track record during the past three years under our management, we have recently decided to market the funds externally to other potential investors.  We are hoping to grow the funds from their current USD 80million, but will look to cap them at a sensible level in order to ensure that we maintain an attractive risk and return profile.

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

KS: We have recently decided to close our Absolute Return Fund, which targets cash + 2-4% with low volatility, and to merge the fund with the Absolute Return Plus Fund, which targets cash + 6-8%.  The main reason for this is that the Absolute Return Plus Fund has exhibited a level of volatility, which we had originally envisaged for the Absolute Return Fund, but with substantially higher returns, over the past three years.  This is partly due to the fall in volatility amongst most asset classes, together with the fact that it has generally been more difficult to make money in arbitrage type strategies due to the sheer weight of money at play in this sector.  We expect these factors to remain in place for the foreseeable future, hence we feel that clients will be better served by focusing our efforts on the Absolute Return Plus Fund.

At some point later this year we may consider launching a fund targeting higher returns and higher volatility.  With the institutionalisation of the industry, which is leading to a greater emphasis on risk management and non-correlation rather than returns, we feel there may be an opportunity to launch a product at the higher end of the risk and return spectrum. 

HW: What is your investment process?

KS:  Our process is a combination of a top-down asset allocation approach together with a very thorough bottom-up manager selection discipline.  We believe that as a group, we can add significant value across all of our mandates through an active asset allocation overlay, which utilises a variety of internal and external sources for our asset allocation ideas.  We also believe that individual sub-strategy returns are predictable based on our assessment of the likely future market and economic environment and that an active strategy can thus both enhance return and reduce risk. Our performance across a number of long-only and hedge fund mandates suggest that we have been successful in adding value from our top-down skills. 

However, we also believe that selecting the appropriate combination of exceptional hedge fund managers in the fund will help us achieve our risk and return objectives.  At Collins Stewart, we have many years experience and significant resource dedicated to selecting managers, both in the traditional long-only world and also in the hedge fund sector.  We have developed a thorough and flexible fund selection process, which combines both quantitative and qualitative skills together with a high level of due diligence.

We have been investing in hedge funds and other alternative asset classes since the business was established in 1996.  Individuals in the team have been investing in hedge funds for over 15 years and collectively the investment committee has well over 50 years of experience in this area.  Our team is also multi disciplined with backgrounds in fund management, fixed income, trading, audit, macro research, economic, engineering and quantitative studies.  We have established a strong and large network of contacts, which means that we are able to access and secure capacity with managers who might not be accessible to our peers.  The long term relationships that the team have built up in both traditional and long-only and hedge funds means that we tend to be one of the first investors contacted when a long-only manager migrates to the hedge fund world.  We believe that all of this gives us a considerable edge over our peers.

In addition to our asset allocation and fund selection skills, our process also includes the key disciplines of portfolio construction and risk management.  For example, when constructing a portfolio, we pay particular attention to the correlation of our underlying managers and how this evolves over time.  From a risk management point of view, we are especially interested in how the underlying funds and portfolios perform in times of market stress and 'fat-tail' events. 

HW: How has your fund performed?

KS: Over the three years ending January 2006 (the period since we assumed management of the fund internally), the Sterling Absolute Return Plus Fund has delivered an annualised return of 13.1% with a Sharpe ratio of 2.8%, whilst the dollar fund has annualised at 11.3% with a Sharpe of 2.3%.  The funds have thus met our performance objectives in absolute terms.  We are also pleased that both funds have performed very well in relative terms against various peer groups, both from a return and risk adjusted performance point of view.  For example, the sterling fund is currently ranked in the top decile of its peer group, both on a compound return and Sharpe basis.

During calendar 2005, the sterling fund returned 12.6% and the dollar fund 11.3%, which was again attractive in both absolute and relative terms.

HW: How many funds are in your portfolio?

KS: We currently have 35 funds in the portfolio with the largest position being around 5%.  We will usually have somewhere between 30-40 funds in the portfolio. 

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

KS: We source manager ideas from a varied and extensive network of contacts, including prime broker introductions, existing managers, other fund of hedge fund managers, our long-only investment network and group contacts.

We initially filter our proprietary peer groups to look for funds that meet our rigorous quantitative tests.  In particular, we are looking for managers who consistently meet their performance objectives, compare favourably with their peer group and appropriate hedge fund indices, and whose risk adjusted returns are superior.  We also analyse a manager's ability to produce consistent Alpha, look at style drift and examine how a manager handles extreme market stress and risks (i.e. fat-tail events).

Having identified a short list of potential managers for investment, we then carry out the appropriate qualitative research.  When interviewing managers, our aim is always to fully understand the manager's edge and the risks and rewards of their particular strategy.  It is vital for us to have a thorough understanding of the manager's process in order that we may judge their strengths and weaknesses as well as judging the conditions under which a particular manager will thrive or under-perform.  We believe that an intelligent understanding of the manager's approach combined with an understanding of whether the macro environment is likely to offer support to the strategy at a particular time is one of the things that sets us apart from our peers.

It is also vital that the manager has absolute integrity on both a personal and company basis.  Trust is the most important factor for us in considering placing our investor's money with a manager.

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

KS:  When we invest with a manager, it will be based upon our expectation that the manager will perform a certain function and will manage risk in a certain way.  Our aim is to invest with managers which have a proven track record of behaving in a certain way - irrespective of the difficulty of markets.  A manager will be removed from the fund for a number of reasons but we particularly focus on issues relating to style drift and risk management.  

Alternatively, the market environment or our global macro economic view, may determine a particular strategy is unlikely to perform well for a period of time.  Such a situation may necessitate the removal of a manager from the portfolio, although capacity issues will of course be taken into account.

Specifically, a manager may be removed for one of a number of reasons including:

  • Performance or volatility drift
  • Reduction in transparency or reporting information becomes unavailable on a timely basis
  • Strategy or style drift
  • Loss of key personnel
  • Trading beyond maximum capacity
  • Excessive and unexplainable growth
  • Loss of focus or 'hunger'
  • Strategy unlikely to perform given global macro economic view
  • Loss of integrity/trust
  • Alpha decay

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

KS: In addition to managing the Absolute Return Plus Funds, we also run a number of other hedge fund mandates and maintain an Approved Fund List of over 60 managers.  We do not set any formal target levels for the number of managers we approve each year.  Our aim is to ensure we retain sufficient options on manager and strategy capacity to be able to dynamically match our portfolio construction requirements with the changes in global macro and economic market opportunities.  However, we will normally have a list of over 10 funds which are 'work in progress'.

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

KS:  From a performance perspective, our broad view for 2006 is that after three very good years of equity market and economic recovery, we expect this year to be a more difficult and challenging environment for both the global economy and for financial markets in general.  Whilst our core belief is that we are about to enter a typical mid-cycle slow down, which has historically been favourable for equities and benign for bonds, there is a risk that recessionary fears will grow as the year progresses.  In addition, we are concerned that geopolitical risks are increasing and are also aware of the fact that periods of tightening global liquidity have often resulted in either a major market corrections or a dislocation type event. 

We also believe that Commodities, Japan and Emerging Markets are in secular (long-term) bull markets, but are vulnerable to a slowing global economy and a general reduction in risk appetite amongst investors.  Consequently, we are likely to retain our exposure to managers looking to benefit from these secular trends, but who we believe should give us some protection during the inevitable corrections that will occur from time to time. 

Generally, we believe that 2006 will present opportunities across many strategies, most notably macro and CTAs, long-short equities, and event driven managers.  We also believe that 2006 may be a better year for credit managers, with a widening in corporate and high yield spreads steepening yield curves and renewed currency market volatility leading to opportunities. 

From an industry point of view, we expect to continue to see consolidation in the Fund of Hedge Fund space, as many funds close due to lack of growth or disappointing performance, and other funds are taken over or merged.

We also expect to see a higher attrition rate from single managers, with many new Fund launches and also a high level of fund closures, again due to performance and size issues.

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

KS:  As we sense that 2006 could be quite an interesting, albeit challenging year for the hedge fund industry, we think we will need to be invested with managers, who have the experience and skills necessary to manage portfolios in periods of greater market stress.  In addition, one of the issues we will face from an asset allocation point of view is ensuring that we have sufficient protection in place against a prolonged reversal in some of last year's bull trends and also against a market dislocation event, which might cause a spike in risk and volatility. 
 
Thus, as always, whilst we are very confident in the current breakdown of the fund, and the quality of our underlying managers, we intend to remain nimble, flexible and alert to both any risks that present themselves and also to the many opportunities that our managers foresee.  We are certainly seeing plenty of new, talented and interesting managers, whom we think will add significant value to the portfolio.  We will also not hesitate to sell any existing managers, either where we feel their edge is being eroded, or where we see problems ahead for the strategy or better opportunities available elsewhere.  Whilst we are happy to enjoy a relatively low level of turnover within the portfolio, we need to recognise that as the industry evolves, and as the market environment changes some turnover will be essential. 

From an industry perspective, we will continue to seek opportunities to grow our Absolute Return Plus Funds, whilst ensuring that we retain capacity with enough exceptionally talented managers to meet our performance and risk objectives.

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

KS:  We believe that there are a number of things that differentiate us from some of our peers:

  • When managing the Absolute Return Plus funds, we employ the same process, skills and experience that has served us so well in running long-only, mixed (long-only and hedge fund) and hedge fund mandates over the years.  We believe our performance track record across a broad range of mandates over a long period of time demonstrates the success of this process.  As far as we are aware, there are not many teams managing long-only, mixed and multi strategy Fund of Hedge Funds.
  • We believe very strongly in an active tactical asset allocation and market timing overlay.  We believe that it is possible to predict with a reasonable degree of accuracy whether the economic and market conditions that lie ahead are likely to be beneficial or not for the various strategies and sub strategies.  Again, our performance track record suggests that we have added value through our asset allocation skills.
  • Our process is designed to be efficient, effective, flexible and timely.  We believe selecting managers is an art, not a science, and believe that we have a unique, practical and thorough approach to manager selection.  Thus, you will find several managers in the Absolute Return Plus Fund, which are not generally held by other fund of hedge funds. 
  • We believe that it is no coincidence that some very large FOHFs and single mangers are struggling to perform in both relative and absolute terms.  As explained above, we think it is very difficult to be nimble, flexible and innovative when managing very large funds.  It is also a problem finding enough attractive trades or managers in this environment.  Consequently, we intend to cap our funds at sensible level in order to ensure that we continue to meet our performance objectives.

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

KS: We pay a lot of attention to risk management, not just the underlying managers in the portfolio, but also, as explained above, in the portfolio as a whole.  Generally, we believe that as the hedge fund industry institutionalises, there has been a move towards risk reduction, which is part of the explanation for generally lower hedge fund returns over the past couple of years.  We are also conscious of the fact that an individual manager's attitude to risk changes over time.  Many managers become more risk averse as their fund size grows and the make up of their client base changes.

Since the Absolute Return Plus Fund is held across most of our client mandates, and also because we have evolved and grown from a private client background (although we also now run a number of institutional mandates), we fully expect and want our managers to deliver a sensible return over cash, whilst managing risk at the same time.  We also manage risk in the portfolio in a number of different ways, and will look at whether the risk level that an underlying manager is employing is appropriate or not given the strategy and the manager's stated objectives.  Also, as explained above, we believe that 2006 will be a more challenging environment for financial markets and hedge funds.  Thus, we are even more focused than normal on managing risk within the fund and on extreme event risk.  We would not expect our underlying managers to be increasing risk at this stage of the cycle.

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

KS:  I am not sure that investors' expectations are moving upwards since our investors, and indeed we, expect consistent returns in excess of cash within a controlled risk environment from our hedge funds.  I think there is a general view that hedge fund returns are more correlated to other traditional asset classes, and equities in particular, than they were.  This is probably correct for certain strategies and funds.  It is also true that, after three years of decent equity market returns, investors are more prone to disappointment with below average hedge fund returns. 

We always try to manage our clients' expectations whatever mandate we may be looking after.  This is especially true in the hedge fund world, where much of the media coverage is still misleading or poor, and where client's expectations and understanding may also be a little unrealistic.  We believe that hedge funds should form a part of most investors' portfolios due to their ability to produce consistent returns ahead of cash whilst protecting capital during more difficult markets.  Whilst we recognise that this changes over time, we try to ensure that our clients understand this and that their expectations are therefore appropriate.

HW: Are you planning any further launches this year?

KS: We are launching a Euro Class Absolute Return Plus Fund (on 1 April), which will invest in the dollar class and hedge any currency exposure back to Euros.  As I have already stated, we may consider a higher return higher volatility product later in the year.

Kevin Boscher was interviewed on 15 March 2006

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